Tablet sales hit Microsoft’s bottom line

Microsoft has admitted that sales of tablet devices are affecting demand for Windows.

Microsoft surprised Wall Street with a better-than-expected profit, helped by resurgent corporate spending after the belt-tightening of recent years. But its shares stayed flat as investors expressed concern about the weakness of overall PC sales amid a faltering US recovery.

The world’s largest software maker is heavily dependent on PC sales, which grew only 3% in the quarter. Now it is starting to feel the heat from investors eyeing the phenomenal take-up of Apple’s iPad.

Sales for its Windows unit fell 30% to $5.054 billion, a little short of analysts’ expectations of about $5.3 billion, due to the lukewarm growth in PC sales. The year-ago figure was swollen by $1.71 billion in deferred revenue and pre-sales from the launch of Windows 7.

In an earnings call, Microsoft’s chief financial officer, Peter Klein, admitted that company had felt the pinch from Apple’s slate success.

Outstanding numbers when you take a first look at it, but when you delve into them, Windows missed expectations by $300 million

“Netbooks… hit their peak last year in Q2, and I think what we’ve seen is over the course of this year in the consumer space, some of that volume being replaced with newer devices like ultra-portables and tablets,” said Klein. “And largely, these are second devices, not primary devices. And that’s caused a little bit of a drag on the consumer side.”

Analysts are also concerned about weakness in the Windows market. “Outstanding numbers when you take a first look at it, but when you delve into them, Windows missed expectations by $300 million,” said Brendan Barnicle, analyst at Pacific Crest Securities.

Sales of smartphones and tablets are expected to grow much more quickly than PCs over the next few years, posing a threat to Microsoft’s key market.

With the migration to mobile devices from desktop computers expected to accelerate, Apple overtook Microsoft to become the largest US technology company by market value last May.

But some analysts argued that fears of tablets and other hot-selling gadgets replacing PCs were over-exaggerated – at least for now. “We’ve gotten over 300 million Windows 7 licenses sold,” said BGC Financial’s Colin Gillis. “I mean, PCs are not disappearing. Put that into perspective with seven million tablets sold last quarter from Apple.”

“Clearly there are disruptions in the landscape, but some of the negative viewpoints are overblown,” he added.

Office sales

Though Microsoft faces longer-term challenges in the PC arena, its other core product, its suite of Office applications, generates strong cash flow.

Sales at its Office unit rose 24% to $6 billion, indicating that businesses are starting to spend more on technology after the recession.

The perennially money-losing online services division, home of the Bing search engine, posted a 19% increase in sales, but saw its loss widen 17% to $543 million. The unit, which is making only slight headway against Google, has lost more than $6 billion in the last five years.

Microsoft reported overall fiscal second-quarter profit of $6.63 billion, compared with $6.66 billion a year earlier.

Sales rose 5% to $19.95 billion, helped by strong sales of its Kinect hands-free gaming system and Xbox consoles, handily beating analysts’ average estimate of $19.15 billion.

“Kinect represents the most legitimate opportunity we have seen for the Xbox to drive some profit,” said Motley Fool senior analyst Tim Beyers.

“The Windows phone looks good. I do think that Windows Phone 7 is proving to be an interesting alternative to the Blackberry.”

Microsoft now has $41.2 billion in cash and short-term investments on its balance sheet.